Recession Looms for the U.S. Economy in 2007 z
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Introduction
The recovery that began in November of 2001 is likely to come to an end in 2007. The main factor pushing the economy into recession will be weakness in the housing market. The housing market had been the primary fuel for the recovery until th e last year, as there was an unprecedented run-up in house prices since 1997. With prices now he aded downward, construction and home sales have dropped off by almost 20 percent against year ago levels. Even more importantly, borrowing against home equity, which had been the main factor fue ling consumption growth, will plummet as many homeowners lack any further equity to borrow against. The result will be a downturn in consumption spending, which together with plun ging housing investment, will likely push the economy into recession. The economy will see a subst antial net loss of jobs, with nominal wage growth slowing as the labor market weakens over the course of the year.
Overview
This recovery has been fueled to a very large exten t by a housing bubble, just as the second half of the nineties cycle was fueled by a stock bubble. Sin ce 1997, average house prices have risen by more than 50 percent, after adjusting for inflation. Hist orically, house prices have moved at approximately the same pace as the overall rate of inflation.
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This unprecedented run-up has not been associated with extraordinary population or income growth, bot h of which have been below their average pace for the post-war years since 2000. It is also not a ssociated with any new restrictions on supply, as housing construction was at near record levels over the period 2003-2005. The run-up in house sale prices was also not associated with any extraordinary increase in rents, which rose only slightly more rapidly than the overall rate of inflation over this period. In short, the run-up in house prices cannot be explained except as a speculative bubble.
This bubble fueled the economy directly through its impact on the housing sector and indirectly through the impact that housing wealth had on consumption. Housing construction and sales account for more than six percent of GDP. The run-up in prices has led to a near doubling of sales of new and existing homes since th e mid-nineties. It has also led to record nationwide vacancy rates for both rental and owner occupied housing. In pa st downturns housing investment has fallen by
30-40 percent. The sector has never seen as much overbuilding as it has experienced in the current cycle. Also, with the huge baby boom cohort now en tering its retirement years, demand for housing should be shrinking relative to the size of the population in the years ahead. Based on past patterns, it is reasonable to expect a drop in output in the housing sector from its 2005 peaks of at least 40 percent. It should reach this bottom by the end of 2007 or early 2008 at the latest.
The wealth effect created by the housing bubble fuel ed an extraordinary surge in consumption over the last five years, as savings actually turned nega tive. (The country’s demographics, with most of the baby boom cohort still in its prime saving years, is heav ily tilted toward saving.) The run-up in prices
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Background data on the housing bubble can be found in
Baker, D., 2005, “The Housing Bubble Fact Sheet,” Center for Economic and Policy Research [h ttp://www.cepr.net/publicat ions/housing_fact_2005_07.pdf] and Baker, D.,
2006, “Is the Housing Bubble Collapsing
?
Ten Economic In dicators to Watch” Center for Economic and Policy
Research [http://www.cepr.ne t/publications/housing_i ndicators_2006_06.pdf].
Recession Looms for the U.S. Economy in 2007 z
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created $5 trillion in excess housing wealth. Conventi onal estimates of the size of the housing wealth effect imply that this wealth would have genera ted an additional $200-$300 billion of consumption
(1.6-2.3 percent of GDP).
It is plausible that the impact of this bubble wealth was actually considerably larger than the conventional estimates imply. Historically, the saving rate in the United States had averaged close to eight percent of disposable income. The savings rate began to decline sharply in the nineties, at least partially in response to the stock bubble, although other factors likely played a role. However, even assuming a baseline savings rate of just four per cent, the current rate of -1 percent implies an amount of excess consumption of almost $480 b illion annually, given current income levels. This higher figure is consistent with data showin g that households were borrowing more than $600 billion annually against their home equity in 2005.